Cointegration portfolios of European equities for index tracking and market neutral strategies
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Christian L. Dunis* is Professor of Banking and Finance at Liverpool John Moores University, and Director of its Centre for International Banking, Economics and Finance (CIBEF). He is also a consultant to asset management firms and an Editor of the European Journal of Finance. He has published widely in the field of financial markets analysis and forecasting, and has organised the annual Forecasting Financial Markets Conference since 1994.
Richard Ho is an associate researcher at the Centre for International Banking, Economics and Finance of Liverpool John Moores University (CIBEF). Richard holds a MSc in International Banking and Finance from Liverpool John Moores University. *CIBEF — Centre for International Banking, Economics and Finance, JMU, John Foster Building, 98 Mount Pleasant, Liverpool L3 5UZ, UK Tel: ⫹44 (0)20 7228 6126; e-mail: [email protected]
Abstract Traditional quantitative portfolio construction relies on the analysis of correlations between assets. Over the last ten years, following the generalised use of the JP Morgan RiskMetrics approach, quantitative portfolio managers have made increasing use of conditional correlations. If correlations are indeed time varying, their many changes unfortunately make them a difficult tool to use in practice when managing quantitative portfolios, as the frequent rebalancing they imply may be very costly. This paper uses the concept of cointegration which relies on the long-term relationship between time series, and thus assets, to devise quantitative European equities portfolios in the context of two applications: a classic index tracking strategy and a long/short equity market neutral strategy. Data are used from the Dow Jones EUROStoxx50 index and its constituent stocks from 4th January, 1999, to 30th June, 2003. The results show that the designed portfolios are strongly cointegrated with the benchmark and indeed demonstrate good tracking performance. In the same vein, the long/short market neutral strategy generates steady returns under adverse market circumstances but, contrary to expectations, does not minimise volatility. Keywords: cointegration, index tracking, market neutral strategy, portfolio optimisation, vector autoregression models
Introduction Financial markets are highly interdependent and for many decades portfolio managers have scrutinised the
䉷 Henry Stewart Publications 1479-179X (2005)
comovements between markets. It is regrettable, however, that traditional quantitative portfolio construction still heavily relies on the analysis of
Vol. 6, 1, 33–52
Journal of Asset Management
33
Dunis and Ho
correlations for modelling the complex interdependences between financial assets. Admittedly, the application of the concept of correlation has been improved and, over the last ten years, following the generalised use of the JP Morgan (1994) RiskMetrics approach, quantitative portfolio managers have made increasing use of conditional correlations. Yet, if correlations are indeed time varying, their many changes across time make them a dif
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